Commodities guide

As the essential components behind just about every other product imaginable, commodities are vital to modern economies. Find out how these volatile yet invaluable natural resources fit into the wider trading world.

Also in Financial markets

Introducing commodities

A commodity is a natural resource that can be processed and sold. Commodities that are tracked in the financial markets include agricultural goods, metals, energies and minerals, among others.

Commodities are the essential components of other manufactured goods – the building blocks for both industrial and domestic products and foodstuffs. They are shipped around the world to meet demand, because not all countries are capable of producing every commodity they need.

The production and consumption of commodities depends on factors such as climate, season and resources – both natural and man-made. Demand is also influenced by a complex interaction between economic factors and consumer habits.

Because of this, commodity prices have the potential to fluctuate greatly.

Commodities are generally traded in very large quantities, either on the cash market or, more frequently, on the futures exchange.

Commodity terminology

Commodities can be grouped according to the similar characteristics they share. Below are some general terms used to classify them:

Soft commodities

These are typically grown, rather than mined or extracted. Softs tend to be very volatile in the short term, as they’re susceptible to spoilage which can suddenly and dramatically rock prices. Producers tend to be heavily involved in the softs market, as they’re often keen to lock in prices for their produce. Alongside the natural growing cycle of these commodities, this creates seasonal fluctuations in prices.

These are typically mined from the ground, or taken from other natural resources. The initial commodity may also be refined into something else, for example oil is refined into gasoline.

Some agricultural products, such as cotton, are also considered hard commodities, as they don’t rot quickly and they are industrial materials rather than foodstuffs. Hard commodities are easier to handle than softs, and are more easily integrated into the industrial process. This makes them a popular choice for investors; for example trillions of dollars’ worth of oil futures are traded each year.

These are commodities that some investors expect will be booming markets in the next few years, but are not currently available to trade as commodity futures. The only way to trade these products is by buying stock in companies that operate in these fields.

Examples include: Water and water rights, ethanol.

Commodity speculation

Major commodities tend to trade in very large quantities and it would be unrealistic for most traders to process them. Instead, and especially because of their volatile nature, commodities are often used for speculation on their prices.

They trade on the commodities market, which is made up of a number of international commodity exchanges. In the commodity market, as opposed to the stock market, everything expires – this is because the commodity will eventually need to be delivered to its final owner.

Commodity futures

Futures contracts, such as CFDs offered by IG, provide a number of benefits that entice both buyers and sellers.

Leverage

Futures trade on margin, meaning that investors only have to put up a fraction of the total value in order to trade.

Liquidity

Because there are normally speculators willing to take on the other side of a given trade, futures contracts are generally fairly liquid. This does vary between individual commodities, however.

Commission costs

Fees are generally lower to buy or sell one futures contract than to buy or sell the underlying commodity.

Ability to go short

You can sell futures contracts just as easily as buy them, so you can profit no matter which direction the price is heading.

Who trades commodities?

There are generally four schools of trader who use commodities.

Hedgers: investors often buy or sell commodities to help manage their risk. In a balanced portfolio, commodities provide a hedge against downward movements in other securities, as they tend to move in the opposite direction, or an unconnected direction, to certain stocks and bonds.

Speculators: investors with a particular opinion on a particular commodity are willing to take on the associated risk in the hope of turning a profit.

Producers: people that grow and harvest commodities may want to enter into a futures contract on them in order to offset the risk of future price movements.

Brokers: these are firms or individuals who carry out the order to buy or sell commodity contracts on behalf of their clients.

Spread bets and CFDs are leveraged products and can result in losses that exceed deposits. The value of shares, ETFs and ETCs bought through a share dealing account, a stocks and shares ISA or a SIPP can fall as well as rise, which could mean getting back less than you originally put in. Please ensure you fully understand the risks and take care to manage your exposure.

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